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IRS PROPOSES NEW REGULATIONS ON INNOCENT SPOUSE CLAIMSRegs to Make Transitional Rules Permanent

In the August 2011 issue of this newsletter I wrote about the fact that the IRS caved in on an important issue regarding innocent spouse relief. The specific issue I discuss there involved claims for equitable relief under code section 6015(f). That section operates as kind of a “catchall” provision that allows citizens to obtain innocent spouse relief in cases where traditional innocent spouse relief is not available. Section 6015(f) gives the IRS broad discretion to consider the totality of a person’s circumstances in deciding whether to relieve them of joint tax debts. Let’s review section 6015 generally.

A Quick Review of Innocent Spouse Provisions

There are three separate avenues of relief potentially available under code section 6015. Taken together, these are known as the innocent spouse rules. I briefly address each of them here.

1. Traditional innocent spouse relief. Code section 6015(b) provides what I refer to as traditional innocent spouse relief. This section has been in the tax code for a long time. It allows a person who signs a joint return to be relieved of the joint liability growing from the return if certain rules are met. They are:

The tax liability is attributable to the unreported income or bogus deductions of one spouse,

The innocent spouse did not know or have reason to know about the understatement of tax,

Under all the facts and circumstances, it is inequitable to hold the innocent spouse liable for the tax, and

The application for relief is made within two years of the IRS’s first collection action against the innocent spouse.

2. The separate spouse election. Section 6015(c) provides an opportunity to switch from a married filing jointly return to a married filing separately return. By switching the filing status, the innocent spouse is no longer on the hook for the joint tax liability. Rather, she becomes solely responsible for her separate tax liability based only on her own income and deductions. This way, she is relieved of a liability attributable solely to her spouse. To obtain this relief, you must:

No longer be married to, or be legally separated from the person with whom you filed the joint return, or

You are no longer a member of the same household as the person with whom you filed the joint return at any time during the twelve-month period prior to submitting the application for relief, and

The application for relief must be made within two years of the IRS’s first collection action against the innocent spouse.

3. Equitable relief. Code section 6015(f) is the third avenue of innocent spouse relief available under section 6015. As I stated above, this is the catchall provision because if you aren’t entitled to relief under either of the first two options, you might qualify under the third option. The test for obtaining relief under section 6015(f) is a facts and circumstances test. The question is focused on whether it’s “fair” to hold the innocent spouse liable for the tax. At a minimum, the IRS considers the following facts and circumstances:

The income on which the tax was not paid did not benefit the innocent spouse beyond the payment of personal (or family) living expenses,

Economic hardship would result if the innocent spouse were forced to pay the tax,

The innocent spouse was abused or under some kind of undue influence,

The innocent spouse was ignorant of the financial affairs of the family or did not participate in the decision-making processes,

The innocent spouse lacked the education or otherwise lacked the capacity to understand the financial circumstances, and

Any other facts and circumstances that would lead the IRS to conclude that it would be “inequitable” to hold the innocent spouse liable for the tax.

For a full discussion of the innocent spouse rules, see my book, Taxpayers’ Defense Manual, pages 207-211.

Confusion About the Two-Year Rule

You will notice that relief under both the traditional innocent spouse rules and the separate spouse election require that a citizen apply for relief within two years of the date of the IRS’s first collection action against the innocent spouse. An application under the equitable relief provision does not have a two-year rule. That is because Congress did not include a two-year rule in section 6015(f) though it did so in the other two provisions.

The IRS in its wisdom decided that Congress must have forgotten to add the two-year rule to section 6015(f) because it included such a rule in the other two provisions. So the IRS fixed Congress’s “mistake” by adding a two-year rule to its regulations. Thus, the IRS operated under the administrative rule that said you must file an application for equitable relief within two years of the IRS’s first collection action or the application would be considered untimely and would dismissed as such.

Along Comes the Tax Court

In 2009, the Tax Court slapped down the IRS’s two-year rule. In the case of Lantz v. Commissioner, 132 T.C. 313, the Tax Court determined that the IRS did not have the authority to add a two-year rule to the law when Congress failed to do so. Not surprisingly, the IRS appealed the case and the Seventh Circuit Court of Appeals reversed the Tax Court. However, in subsequent cases that came before the Tax Court (and which were appealable to courts other than the Seventh Circuit), the Tax Court continued to hold that the two-year rule was invalid.

Working with my Congresswoman following the Seventh Circuit’s Lantz decision, we got a bill introduced in Congress in July 2011 to amend code section 6015(f). The amendment would make it clear that there was no statute of limitations on filing a claim for equitable relief. The IRS started feeling pressure from several congressional angles and in July 2011 relented on its position regarding the two-year rule. The IRS issued Notice No. 2011-70 which officially pulled the plug on the two-year rule and simultaneously set up new rules for making claims for equitable relief going forward. The rules offered another bite of the apple for those who filed claims in the past but had them denied solely because of the two-year rule. For the full details of the rules set up by Notice 2011-70, see the August 2011 issue of Pilla Talks Taxes.

New Regulations Proposed

The procedures set forth in Notice 2011-70 were transitional rules put in place to guide the public until new regulations could be established. New regulations are now proposed. The proposal will, among other things, amend Rev. Reg. section 1.6015-5(b) by inserting a new subsection (2). The proposed language reads:

(2) Equitable relief. To request equitable relief under §1.6015-4, a requesting spouse must file Form 8857 or other similar statement with the IRS within the period of limitation on collection of tax in section 6502 or within the period of limitation on credit or refund of tax in section 6511, as applicable to the joint tax liability. If a requesting spouse files a request for equitable relief under §1.6015-4 within the period of limitation on collection of tax, the IRS will consider the request for equitable relief, but the requesting spouse will be eligible for a credit or refund of tax only if the limitation period for credit or refund of tax is open when the request is filed (assuming all other requirements are met, including the limit on amount of credit or refund prescribed in section 6511(b)(2)). Alternatively, if a requesting spouse files a request for equitable relief after the period of limitation on collection of tax has expired but while the limitation period on credit or refund of tax remains open, the IRS will consider the request for equitable relief insofar as tax was paid by or collected from the requesting spouse, and the requesting spouse will be eligible for a potential credit or refund of tax. If neither the section 6502 nor section 6511 limitation period is open when a requesting spouse files a request for equitable relief, the IRS will not consider the request for equitable relief. See §1.6015-1(g).

The proposed regulation continues to refer to a “period of limitation” in which a claim for equitable relief must be filed. However, this is clearly not the same two-year period the Tax Court in Lantz struck down. In fact, there are two statutes of limitation that now control the timing of claims under section 6015(f). I address each of them.

1. Code section 6502. Code section 6502 is the collection statute of limitations. That section provides that the IRS has ten years from the date of the assessment in which to collect the tax. The details of the collection statute of limitations are set forth in my Tax Amnesty Package. Under the proposed regulation, the first question is whether the assessed tax is open for collection. If so, the taxpayer may submit a request for equitable relief under section 6015(f).

2. Code section 6511. Code section 6511 is the refund statute of limitations. That section generally provides that a taxpayer may claim a refund of taxes paid (including all additions to the tax) within three years of the date the return is filed or within two years of the date the tax is paid, whichever date is later. For the details on the Claim for Refund process, see my book, Taxpayers’ Defense Manual. Thus, if the collection statute has expired but the two-year rule has not expired, the taxpayer may file a Claim for Refund using a section 6015(f) argument as the basis of the claim.

The interaction between these two statutes and section 6015(f) is quite simple. The first question is whether the collection statute is open and the tax remains collectible. If so, a claim for equitable relief will be considered timely, regardless of when collection action first began. If the statute is closed but the IRS didn’t collect the tax, the question of equitable relief is moot because the tax is no longer legally collectible. They simply cannot get the money in any event.

If the tax was paid, now the issue of the refund statute of limitations comes into play. A Claim for Refund based upon section 6015(f) will processed by the IRS. To be timely, a Claim for Refund must be filed within three years of the tax return filing or within two years of the date the tax is paid. Let me illustrate this.

Suppose you file a joint tax return with your spouse on April 15, 2011. The IRS assesses additional tax due to failures attributable to your spouse. The tax is paid in full by levy against your bank or wages on June 1, 2013. You can file a Claim for Refund after June 1, 2013 (the date of payment) and before April 15, 2014, which is within three years of the return’s April 15, 2011 filing date.

As to the two-year rule, assume the same filing date as shown above. However, the tax is not paid before April 15, 2014. Rather, the tax is paid by levy on wages or bank accounts between June 1, 2015 and December 31, 2015. Once the tax is paid in full, you have two years from that date in which to file a Claim for Refund. Anything paid within two years of the claim’s filing date will be subject to refund. Thus, if you file the Claim for Refund on or before June 1, 2017, the entire amount paid would be subject to refund. See: Taxpayers’ Defense Manual for all the procedures on filing a Claim for Refund.

A Reconsideration Process

The proposed regulations would add a reconsideration process for reviewing denied claims for innocent spouse relief. First of all, it’s important to understand that denied claims for innocent spouse relief may be appealed to the Tax Court. You have ninety days from the date of the IRS’s letter denying your application for relief in which to file a petition in the Tax Court. See: Code section 6015(e).

But apart from the Tax Court appeal, section 1.6015-5(c)(2) of the proposed regulation sets up a reconsideration process. The proposed regulation reads in part as follows:

Pursuant to §§1.6015-1(h)(5) and 1.6015-5(c)(1), a requesting spouse is generally entitled to submit only one request for relief and receive only one final administrative determination. Nevertheless, if a requesting spouse submits new information (including new facts, evidence, and arguments not previously considered) to the IRS after the IRS issues a final administrative determination to the requesting spouse, the IRS may reconsider the requesting spouse’s request for relief under its established reconsideration process.

When the IRS considers “new information” not previously considered, it will issue a notice concerning the determination on the reconsideration. If the IRS continues to rule against your claim, the notice denying the reconsidered claim does not give rise to renewed Tax Court jurisdiction. The jurisdiction of the Tax Court is limited by statute. As stated above, you have ninety days from the date of the IRS’s denial of your initial claim in which to file a petition with the Court. If you fail to file in a timely manner, the Tax Court loses jurisdiction over your claim. A request for reconsideration will not resurrect the Court’s lost jurisdiction.

One Bite of the Apple

The final point of significance I find in the proposed regulation relates to multiple innocent spouse applications. Section 1.6015-5(c)(1) provides that once you’ve received a denial of an innocent spouse application, you may not file further applications “including through the CDP hearing procedures under sections 6320 and 6330.”

This is important to understand because it might affect the manner in which you pursue an innocent spouse claim. Under code section 6330(c)(2)(A)(i), you may raise in a Collection Due Process appeal “appropriate spousal defenses.” Section 6330(c)(2)(B) provides that challenges to the underlying tax liability (i.e., “I don’t owe this – here’s why”) can be raised in a CDP appeal if you did not receive a “notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”

Raising an innocent spouse claim separately under code section 6015 and its administrative procedures will foreclose the ability to raise the claim through the CDP process later. Therefore, you must be careful to consider your options before simply filing an application for innocent spouse relief through normal channels, that is, the non-CDP process.

In most cases, the CDP process is by far the more desirable process in which to make a claim for relief. For example, applications for penalty abatement or an Offer in Compromise filed through normal administrative channels are subject to administrative appeal but not judicial appeal. Thus, if the IRS’s Appeals Office denies your claim, you’re stuck unless you pay all the tax. But on the other hand, such claims filed as part of a CDP appeal are subject to judicial review by the Tax Court. In those cases, the Tax Court reviews the IRS’s determination for abuse of discretion. If the agency is found to have abused its discretion in denying your claim, the Tax Court will send the case back for another hearing. In this way, the CDP process gives you leverage over the IRS that you don’t otherwise have.

In the case of an innocent spouse application, timing is important. If the IRS has not issued a Final Notice, Notice of Intent to Levy and Notice of Your Right to a Hearing, Letter 1058, you actually have two separate potential avenues for relief. The first would be to file an administrative claim for innocent spouse relief. If that claim is denied, you have Tax Court appeal rights under section 6015(e). This gives you leverage as discussed above.

In cases where a Final Notice has not been issued, you might want to wait for the Final Notice before filing your innocent spouse claim. The advantage is that in your CDP hearing, you may not only raise “appropriate spousal defenses” but you can also raise “challenges to the appropriateness of collection actions” should you lose the innocent spouse claim. See: 6330(c)(2)(A)(ii). That is, you can cover all your bases through the CDP process, which cannot be done solely through the innocent spouse administrative process.

But in cases where a Final Notice has already been issued and you’ve lost your CDP appeal rights (because the appeal must be filed within thirty days of the date of the Final Notice letter), your only option is to file an administrative claim under section 6015(e). And while it’s certainly true that the denial of such a claim is reviewable by the Tax Court, it’s also true that you will not be able to argue about the “appropriateness of collection actions” in the context of the innocent spouse procedure.

The Burden of Proof

While the IRS has relented on the two-year rule, it remains true that the burden of proof in an innocent spouse case is on the taxpayer. The IRS does not have to prove that innocent spouse relief does not apply. You have to prove that it does. Therefore, you must be careful to fully develop and document all the facts related to your claim. The simple fact that we no longer have the two-rule rule impeding section 6015(f) claims does not mean the load is remarkably lighter.

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